This past week I opened a Roth IRA with Vanguard. One thing that bothers me about my current deferred compensation plan at work is that when I start withdrawing the money I will have to pay taxes on it at the full rate (currently 25%) whereas if the money were not in a retirement account and I used after-tax money the gains, at least, would only be taxed at 15% for long-term capital gains. The Roth allows you to pay *no* taxes on the gains.
As it turns out whether you pay taxes now (Roth IRA’s are funded with after-tax money and aren’t deductible) or later (conventional IRA’s, 401k’s or deferred comp treat withdrawals as normal income) if the tax rate is the same the result is the same. For example if you have $10,000 and invested it in a mutual fund that got an average return of 8% a year for 15 years:
1. For a Roth IRA you take $10,000 in salary, pay 25% in taxes for $7,500. Then you multiply that by 8% interest for 15 years to get $23,791.27.
2. Under Deferred Comp you take $10,000, pay no taxes now, and it draws 8% interest for 15 years for $31,721.69, but then you would have to pay taxes on that which I can only assume would still be 25%, bringing me right down to $23,791.27 again.
As long as the tax rate is the same you’re just applying it at a different point, but the result is the same. However both plans still beat the alternative which is to put after-tax money in a taxable account and then pay even more taxes on the gains. So I’ve got this after-tax money sitting around that I probably won’t spend for a long time and I figured I would do a Roth IRA.
The real difference in plans is in how you can take the money out. For instance with IRA’s and 401k’s you can’t take the money out until you are at least 59.5 years old. But with the deferred compensation plan I’m in I can take the money out when I quit without penalities (though I would have to pay taxes). I figured it was always a lot more likely I would quit work than retire. So if I went to school full-time or spent a year in Tibet or something I could use my deferred compensation, but a 401k would just sit there waiting for me to get old.
With the Roth IRA the 59.5 year rule only applies to the gain on the investment, not to the principle. So if I contribute $3,000 and it grows to $4,000, I can take out my $3,000 any time and pay no taxes or penalties on it (taxes were already paid on that money when I got it in the first place). You can even take the gain out for a first-time home purchase, but I’ve already blown that since I have my first house.
So anyway, I can only contribute $3,000 a year, so I thought I would try it and at least I won’t have to pay taxes on dividends and gains on that money which I was doing now by just leaving it in a taxable investment account.
I put the money is Vanguard’s Small Cap Value Index fund. It invests in companies with a market value between $200 million and $1.5 billion that have a lower than average Price to Earnings ratio. Over time this market segment is supposed to have the highest growth in value of any. Plus I have so much money in the S&P 500 index of large cap companies that this represents pretty good diversification from that. After one day I’m up $15 so it must be working.